ALLOCATION OF RISK UPDATE: Interplay of Insurance, Indemnity, & Release Clauses

Any analysis with respect to the allocation of risk in a commercial lease will inevitably draw upon the principles set out by the Supreme Court of Canada in the “Trilogy”: (1) Pyrotech Products Ltd. v. Ross Southward Tire Ltd., (1975) [1976] 2 S.C.R. 35; (2) Cummer-Yonge Investments Ltd. v. Agnew-Surpass Shoe Stores Ltd., (1975) [1976] 2 S.C.R. 221; and (3) Smith v. T. Eaton Co., (1977) [1978] 2 S.C.R. 749. Each of these Trilogy cases involved attempts by a landlord (or its insurer by way of subrogation) to recover damages from a tenant as a result of fire damage caused by each tenant’s negligence. In all three cases, the Supreme Court found in favour of the tenant and dismissed each landlord’s action on the basis of the principle of immunity. The Supreme Court established the principles specifying that in a landlord-tenant relationship where there is an express obligation by one party to obtain property insurance or an express obligation by the tenant to contribute to the costs of insurance, each operates as an assumption of risk for loss or damage caused by the other party, including for acts of negligence. Canadian Courts continue to rely on the Trilogy principles in dismissing actions brought by innocent parties (or their insurers) against negligent parties, suggesting that only the most clear, express, and unambiguous language will provide an exception to the principle of immunity.

In Deslaurier Custom Cabinets Inc. 2017 ONCA 293, (leave to appeal to SCC refused), 2017 CanLII 68350, the tenant leased several units in the landlord’s commercial building. On January 1, 2009, a fire occurred due to repairs that were being made by the landlord’s contractors, causing significant damages to the building including the tenant’s premises and its property. The building was a total loss and was eventually demolished. The tenant made a claim to its insurer but the amount it received was insufficient to fully cover its losses. The tenant brought an action against the landlord to recover costs for its uninsured property and the tenant’s insurer sought recovery of the subrogated loss. The landlord defended on the basis that: (1) the tenant assumed the risk of loss; and (2) if the tenant had added the landlord as an additional insured to its policy as required by the lease, the tenant and its insurer would be precluded from claiming against the landlord.

The motion judge held that the landlord’s indemnity took priority over the tenant’s obligation to insure – meaning, the landlord had assumed responsibility to indemnify the tenant in respect of any damage to its property and business caused by the landlord’s actions or actions of its agents and contractors. The Ontario Court of Appeal rejected the motion judge’s interpretation of the lease and decision. Instead, the Court found that the tenant’s obligation to insure against all risk of loss or damage to its own property caused by fire relieved the landlord from liability. In addition, the Court held
that the tenant’s insurer should not be able to bring a subrogated claim against the landlord because it would not have been able to bring such a claim if the tenant had complied with its obligations under the lease to name the landlord as an additional insured.

While the tenant’s application for leave to appeal this decision was pending, the Supreme Court of Canada directed the Court of Appeal to reconsider its decision in light of the Supreme Court’s ruling in Ledcor Construction Ltd. v. Northbridge Indemnity Insurance Co., 2016 SCC 37. The Court of Appeal did so, but noted that the Ledcor principles regarding standard form contracts would not apply to this case as the lease in question was a negotiated contract and therefore, the standard of review applied in its previous decision was correct. Once again, the tenant sought leave to appeal, but on October 9, 2017, the SCC provided finality by dismissing the tenant’s application for leave. By refusing leave to appeal, the Supreme Court inferentially affirmed the precedential value of the Trilogy principles and that only in the clearest of cases will it be possible to rebut the principle of immunity.

But just when all hope seemed lost for landlord-insurers, the Ontario Court of Appeal threw them a life-line with Royal Host v. 1842259 Ontario Ltd., 2018 ONCA 467.

In Royal Host, the tenant leased premises to operate a restaurant. A fire in the tenant’s restaurant kitchen caused damage to the building. The damage was covered by the fire insurance covenanted by the landlord to be taken out under the lease, for which the tenant contributed to premiums. The insurer indemnified the landlord but brought a claim against the tenant through its right of subrogation. Relying on the Trilogy principles, the trial judge held that the insurer’s claim was barred on the basis that when a landlord covenants to obtain insurance for fire damage, the landlord is barred from recovering losses from the tenant absent clear, express, or unambiguous language in the lease stating otherwise.

However, the Ontario Court of Appeal found that the motion judge erred in his interpretation of the lease and the application of the Trilogy principles on the basis that there was clear, unambiguous, and sufficient language that rebuts the principle of immunity. In Royal Host, the tenant’s indemnity clause included “notwithstanding” language which explicitly states that “the tenant remain[ed] liable for its own negligence notwithstanding the landlord’s covenant to purchase insurance and the tenant’s contribution for the cost of that insurance.” As a result, a subrogation claim in relation to the exception clause would not have been contrary to the parties’ intentions and the insurer could bring a subrogated claim for damages. The Court of Appeal found this language sufficient to allow the landlord’s insurer to bring a claim against the tenant (note: the Court did not rule that the tenant was negligent and was responsible for the loss, but rather that the landlord’s insurer was not prevented from bringing a claim for same.)

Although we would not call the decision in Royal Host surprising given the express language in question, it is interesting to see our Courts opening this window for insurers despite all the previous case law and general reluctance to do so in the past. We now have a small handful of cases, including Royal Host and Lee-Mar Developments Ltd. v. Monto Industries Ltd. [2000] O.T.C. 250 (Ont Sup Ct J), affirmed (2001), 146 O.A.C. 360 (CA), which illustrate that it is possible to contract out of the Trilogy principles.

Subtenant’s Security of Tenure Following Abandonment by Tenant

What right to stay does a subtenant have? Subject to a subtenant’s statutory rights (discussed below), in the event the head lease is cancelled, terminated, or surrendered, the subtenant cannot force a head landlord to recognize its tenancy or allow it to remain in possession of the subleased premises unless there is privity of contract between the landlord and the subtenant (e.g., non-disturbance agreement or tri-party consent to sublease) and the contract in question provides non-disturbance comfort.

In the Province of Ontario, subtenants enjoy statutory rights pursuant to the Commercial Tenancies Act (Ontario), R.S.O. 1990, c. L.7 (“CTA”): Section 17 (Surrender of Lease); Section 21 (Termination of Lease and Relief of Forfeiture); and Section 39(2) (Bankruptcy of Tenant). In particular, Section 17 provides that if the lease is surrendered, the subtenant becomes the tenant of the landlord under the terms of the sublease. In other words, the landlord steps into the shoes of the sublandlord (the tenant) and accepts the sublease as if it had entered into it directly with the subtenant.

In Smiles First Corporation v. 2377087 Ontario Ltd., 2018 ONCA 524, the Ontario Court of Appeal grappled with the issue of whether a landlord’s acceptance of rent from the applicant, who claimed to be an assignee, amounted to a recognition of an equitable assignment. The Court also ruled on the impact a lease abandonment has on a subsisting sublease.

On January 12, 2015, the landlord entered into a lease with the tenant. The tenant then subleased the premises to the applicant subtenant (Smiles First). Under the sublease, the subtenant agreed to pay a significantly higher rent than the tenant was paying to the landlord under the head lease.

Disputes later arose between the parties under both the head lease and the sublease. On October 31, 2016, the tenant and subtenant executed an assignment of the head lease to the subtenant, but without the head landlord’s consent. In November 2016, the head landlord proposed a settlement agreement to the tenant and subtenant which, among other things, required the tenant to vacate the premises. The tenant signed the agreement and abandoned the premises as of November 1, 2016. The subtenant did not execute the settlement agreement but began paying rent in November 2016, which was accepted by the landlord.

Not surprisingly, Smiles First argued that it was the “official tenant” under the head lease by virtue of the executed assignment, and in the alternative, even if the assignment was invalid, that the head lease was equitably assigned once the landlord accepted rent from Smiles First after the head tenant abandoned the premises. However, the landlord took the position that the applicant (Smiles First) was a month-to-month occupant (and not an assignee) under the lease. Soon after, the landlord provided Smiles First with a notice of termination of the monthly tenancy. Smiles First sought a declaration that the assignment (as between tenant and subtenant) was binding and an order for relief from forfeiture.

The application judge found that the assignment was not legally effective because the landlord’s consent, as required by the terms of the assignment clause in the head lease, was not obtained. As well, the head lease only allowed the tenant to assign its rights to the lease if it was not in default, but in this case, the tenant was in arrears of rent.

The application judge also found that the landlord’s acceptance of the rent during the time when the parties were engaged in settlement negotiations was not an indication of the landlord’s intention to treat the proposed assignment as valid. Moreover, neither the landlord’s acceptance of rent nor its willingness to allow the proposed assignee to remain in possession of the premises automatically results in an equitable assignment of the lease. The application judge further held that the acceptance of rent did not constitute a waiver or estop the landlord from asserting its rights under the lease.

The applicant appealed the decision but the Ontario Court of Appeal held that there was no reversible error in the application judge’s analysis of the issues regarding the assignment, or lack thereof, of the lease. Although the Court found the applications judge was correct in finding that the tenant had abandoned the head lease as part of its settlement with the landlord, the Court held that the judge had erred in accepting the landlord’s argument that the surrender of the head lease resulted in termination of the sublease and the judge’s finding that Smiles First was not a subtenant. However, the application judge had properly refused Smiles First’s request for a declaration that pursuant to the sublease it was entitled to remain in the premises “on the same terms and conditions as the Head Lease.” The Court explained the law on this area is well settled (citing case law and Section 17 of CTA) and that when a head lease is surrendered, the sublease survives and the subtenant is entitled to possession of the premises “under the terms of the Sublease.” Accordingly, Smiles First was entitled to relief against the landlord’s attempt to terminate its possession of the premises (on the basis that it was merely a monthly tenant) and the termination notice was of no force or effect. 

What makes the Smiles First case especially interesting is that a subtenant who attempted to take an unlawful assignment of the head lease was still entitled to relief from forfeiture as a subtenant.

Stay tuned for Part 2 in our Fall 2019 issue in November.

Special acknowledgement and thanks to Stephen Messinger and Nusrat Ali (Student-at-Law), for their valuable assistance in preparing this article.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.